Why Proxy Statements Are Worth Reading

Corporate Governance Speaks Volumes, Especially with Respect to Time

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This is a guest piece written by Darius Mortazavi, an Associate at The Diff who works on various growth and research projects.

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The best kind of alpha comes from a signal that a) persists and b) goes undetected. This type of signal is generally buried in the data: it’s either an obscure correlation, a macro indicator, or some unique bit of “alternative data” that you discovered. If that signal does persist, and if it does go undetected, you should be able to structure a trade that consistently produces profits. The next best kind of alpha is fleeting: it comes from information that hasn’t been baked into the price, but is destined to be baked in soon. Traders capitalize on alpha like that by taking a long or short position, with a magnitude proportional to their confidence.

A simple version of this takes place immediately after a company posts earnings and submits an 8-K (or a 13F)—the earnings numbers are buried in there, so analysts rapidly update their models and tweak their position. Other, less-structured information, like that which you’d find in a block of text, gets priced in marginally slower. And as nuance to that information increases, so does the amount of time it takes for the well-informed to make their bets. One such source of this more nuanced information can be found in another filing: the DEF 14A.

DEF 14A is the designation the SEC gives to what is known as the proxy statement. Proxy statements must be posted by companies at least 20 days before a proxy vote takes place, so either a) right before the annual shareholder meeting, or b) shortly after a company makes a large announcement (usually this will happen right before a company sells some assets or is considering a merger). Which means that you’ll see a pretty constant trickle of proxies in M&A heavy industries, but just a single annual update in other industries.

So—what’s in this “proxy statement”? The meat of the 20- to 150-plus-page document is relatively consistent: first you’ll see a note that provides context for the meeting, then you’ll find details on who owns a significant share of the company, how much directors and officers own, and then some detail on how directors are elected, what the structure and compensation of the board looks like, and how executives are compensated for their valiant efforts.

Digging into executive compensation can be fruitful; not because you learn how much a director or executive was compensated, but because you learn what a director or executive is paid to do. For example, Exxon’s CEO is paid an annual bonus that is based solely on annual earnings (i.e. he gets a big bonus when oil prices are high), while Chevron’s CEO is subjected to a much more granular “corporate performance rating” which boosts his bonus by that calculated factor.

This granularity, or lack thereof, impacts the way that a CEO operates. Consider the “Energy transition” metric listed above: while it’s just a minor component of the Chevron’s CEO’s total compensation, it does tell you that their CEO is incentivized to make climate-related progress sooner rather than later (while Exxon’s CEO’s climate incentives are only present in their long-term incentives). Some energy companies—particularly smaller caps that Blackrock doesn’t touch, like Northern Oil and Gas—won’t mention the climate at all. In fact, their CEO is paid a bonus in a rather discretionary manner that is “guided” by the company's total shareholder return relative to others in their peer group.

If you look at enough proxy statements you’ll quickly realize that near-term compensation, like a CEO’s base salary and cash bonus, are just a minor fraction of their total compensation. The bulk of it, roughly two-thirds, comes from equity grants either in the form of stock, restricted stock, or the option to buy stock.

This form of compensation is fairly well known in the public sphere, but probably misunderstood at large. The most recent instance highlighted Elon Musk’s comp structure, which naturally led to headlines that misrepresented his actual earnings. There was no $50bn payday; he was granted the option to buy 100.8m restricted units of Tesla stock at a price of $70/share because he met the market cap and profitability guidelines laid out by Tesla’s compensation committee two years prior. His cash payday will only come after he sells those shares, and he can’t do that until the shares are unrestricted (he’s required to hold them for 5 years).

It’s true that the CEO’s incentives can be informative on their own, but the real alpha comes from detecting changes to those incentives, or changes to other governance structures disclosed in the proxy statement. It’s these subtle differences that Mike over at Non-GAAP is particularly adept at identifying. For instance, the generally accepted best practice for equity grants (like those given to Musk) is to grant equity at the grant date stock price. Mike noticed that LivePerson mentioned in a footnote that their CEO was granted equity based on the average share price from the previous 30 days, not the price on the grant date. So when the company released positive material information that shot the stock price up, the CEO had the right to buy stock at the old price.

This “spring-loaded” compensation structure isn’t performance-based like Musk’s, and if you think it sounds a bit like insider trading, you’ll find yourself in good company. It’s not all too different from the old options backdating scandals seen in the early 2000s. Several executives, most notably Steve Jobs, got a lot of media (and legal) attention for dating options grants to whichever date had the lowest stock price, essentially giving management undisclosed extra compensation.

Ultimately, proxy statements are worth reading because they contain the type of information you can’t quickly squeeze into a model. Noticing a pattern requires knowledge of corporate governance norms, awareness of what their peer groups are doing, and some sense of whether certain corporate actions, i.e. mergers and acquisitions, are likely to occur in the near future.

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Read More in The Diff

The Diff has covered the direct and indirect impacts of managements’ incentives and corporate governance in a few different pieces:

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